The Ticking Time Bond

The greatest issue facing fixed income investors today is the artificial zero percent interest rate, thrust upon them since 2008. This is essentially an experiment implemented by the Federal Reserve, one of epic proportion. In this report, LCM Capital Management (LCMCM) provides income investors clear insight into the potential pitfalls and possible catastrophic consequences lurking below the surface in myriad bond mutual funds, and the many offshoots that are pushing the envelope of risk because of record low interest rates.

The Federal Reserve’s policy has cost conservative investors in excess of $300 billion a year in income and forced over $8 trillion* into much riskier asset classes.

Municipal Bonds: The key to this area of investment is having a fundamental understanding of the underlying fiscal discipline and revenue stream of a particular municipality or state. Chicago, or the state of Illinois, are good examples. Although there are pockets of opportunity in current fiscally sound municipalities (DuPage County, North Shore, etc.), there are landmines everywhere. Many city and state retirees will receive between $3.5 - 6 million over their lifetime payouts.** These pension legacy costs are simply unsustainable; making long term investments in these states and municipalities ill-advised.

As a point of reference, San Bernardino, Stockton, Vallejo, Harrisburg, and Detroit have all filed and emerged from Chapter 9 bankruptcy with only the bondholders taking a 20-30% haircut on their investments. The public unions did not make any significant concessions outside of general city workers (i.e. librarians) having their 3.50% cost of living removed. Look for this trend to continue.

Many municipal bond mutual funds hold high risk, high coupon paper from Puerto Rico, New York, Connecticut, New Jersey, etc. in their portfolios in an attempt to try and offset their high internal fees and current record low interest rates. To complicate the issue many funds are on margin or own securities that are nonrated, illiquid, have long maturities, or have holdings categorized as “other.” Unfortunately, it is up to you to understand the internal workings of these funds; otherwise 2008 will pale by comparison.

Sovereign/Emerging Market Debt: Global debt now exceeds an unimaginable $100 trillion, which is up over 40% since the financial crisis. While some opportunity exists for higher yields, generally the risk far outweighs the gain, especially for the retail investor. Many countries outside of the U.S. do not have the ability to print money (e.g. Greece, Portugal, etc.), putting their debt in an even more precarious position. As with all world debt or country crises, these pieces of paper become virtually frozen in times of uncertainty, causing buyers to disappear. As a result prices plummet. In good times you may enjoy perceived gains and slightly higher bond fund yields, but during times of panic you will see precipitous declines, especially if leverage or questionable derivative vehicles are used.

As central banks around the world have all joined the race to zero percent interest rates, some European yields (under 5 years) have gone negative. You actually are paying someone to safeguard your money. Over $2+ trillion is invested in negative yields and an equal amount that barely exceeds zero. How can a bond fund possibly pay a positive yield of 3-4%? Traditionally, spreads on these bonds are much wider than U.S. Treasuries. In critical times it will be difficult to get a quote. Know what is in your bond fund.

Corporate Debt: For many years, investors could expect better yields for investment grade debt, but not now. With such synthetically low rates, many corporations have issued record amounts of debt (large technology, industrial, financial companies) and used the proceeds to buy back their common stock, thus inflating their earnings. This creates a slow motion leveraged buy-out. With 30 year paper approaching 1.75-3.50%, who can blame them? The systemic problem with this is that eventually it must be paid back. Complicating the issue is that many of the bond debentures have been rewritten, removing the protection that senior bondholders previously demanded. If interest rates return to historic norms, you have a recipe for potential disaster when you add high fees, leverage, skinny yields, long dated maturities, distribution costs, soft dollars, and some questionable preferred stocks.

High Yield (Junk) Bond: The risks are similar to, but worse than, corporate debt. The days of Drexel Burnham Lambert, creator of high yield securities, are long gone. Yields for entities like RJR Nabisco or Time Warner at 9-12% coupon rates that could pay off their debt with real cash flow are history. With junk debt only 100-150 basis points over treasuries, the lowest spread in modern times, the risk/reward simply is not there. In fact, today’s manufactured low interest rate environment has created a false sense of security in many of these companies who not that long ago could have been forced into bankruptcy.

Real Estate Investment Trusts (REIT’s), MLP’s, LLC’s: While on the surface the yields of these funds are attractive, in many cases you are simply getting back your original investment in the form of distributions. This reduces your cost basis and significantly increases your potential capital gains tax. The internal fees and layers of cross trading are staggering, with limited and general partners having their own complex fee arrangements. Outside of being an accountant’s nightmare, these funds have enjoyed years of supposedly higher simulated yields. However, illiquid assets, drained cash reserves, and leverage ultimately will work against them in difficult times. Caveat Emptor.

Fixed Annuities: Without any elaboration, these vehicles are only as good as the underlying insurers, who not only are notorious for high fees but also have to invest in all the aforementioned vehicles to overcome what used to be an easy investment into U.S. government bonds. No more. Many of the companies are nearing junk status, and in an inevitable looming recession could be the next shoe to drop. Unlike banks, most insurance companies are not backed currently by the U.S. taxpayer.

In summary, the greatest risk in all of these products, outside of high fees, margin, subjective positions, potential illiquidity and an “other” category, is something called forced liquidation. In difficult times, these funds may need to do mass selling when no one is buying. Once forced liquidation begins, you have no control over the result.

* Using average money market/CD rates from late 2007.
** Including annual 3-4% cost of living increases, premium healthcare coverage, last 3 year wage average, high watermark starting point and assuming an 80-90 year old life expectancy with a 52-57 year old beginning retirement age.